Dr. Dan Steinbock is Research Director of International Business at India China and America Institute (U.S.A.) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore). For more see: http://www.differencegroup.net

At the surface, foreign direct investment (FDI) into China has been declining for months. In 2012, it fell 3.7 percent to $111.7 billion, according to the Ministry of Commerce. In January, the drop was 3.7 percent –the lowest level since 2009.

Dan Steinbock

Internationally, the decline has been portrayed as a sign of decreasing foreign interest in China. This, in turn, has been attributed to a wide array of perceived causes, including China’s falling attractiveness as a FDI destination, rising costs and wage inflation, as well as potential instability.

At the same time, an expansive array of political observers and financial analysts have regarded the trend line as an indicator of a migration of foreign multinational companies and their FDI from China to rival lower-cost regions and nations, in emerging Asia and elsewhere.

It is a fascinating story. There is only one problem about it. It is based on a statistical myopia.

Two stories, one narrative

True, data by China’s Ministry of Commerce has been disappointing, but the balance of payment data by China’s central bank offers a more positive picture of foreign investment in China.

The former captures new projects from the overseas, but ignores reinvested earnings from foreign companies that already operate in the mainland. In contrast, the latter data by the central bank, which does include these earnings, offers a
more bullish FDI picture.

In brief, while the number of new investment projects suggest relative decline, the volume of reinvested earnings indicates that existing multinationals operations are expanding.

Despite the two FDI stories, there is only one narrative. In the continent-size Chinese economy, most FDI was concentrated on the 1st and 2nd tier cities, until recently. What the new investment data reflects is an intensifying shift to other tiers of megacities, the inland and the west.

In other words, the volume of FDI in China is expanding, but its geographic composition is shifting. Due to the fiscal crisis in the United States, Europe’s sovereign debt crisis and Japan’s lost decades, FDI flows from the developed economies have been slowing down. Nonetheless, FDI into China is not just doing well, but China is now the world’s top destination for FDI.

Taking into account the decline of global FDI flows, the Chinese performance is impressive – and far from disappointing.

The low-cost relocation story

Initially, foreign multinational companies came to China to benefit from low prices and low costs. At the time, China was used mainly as an export platform. Today, most multinationals come to or expand their operations in China not just for reasons of cost or price, but for market access. As China’s growth model will gradually shift from investment and exports to consumption, the mainland has potential to become one of the fastest-growing consumer markets worldwide.

Smart multinationals know that they can still enjoy cost-efficiencies in China’s lower-tiered megacities, inland and the west. Meanwhile, China’s leading urban centers are about to become global market engines and thus very attractive destinations for foreign FDI for years to come.

True, in the recent years, most East Asian countries, particularly China, have experienced rising wages and production costs, which have served to boost the relative competitiveness of manufacturing in Southeast Asian nations.

Those MNCs that have favored China for mainly low-cost reasons have been the first to relocate to lower-cost destinations, as evidenced by some textile producers that have moved to Bangladesh, Sri Lanka and other locations in South and Southeast Asia. In these alternative locations, they enjoy greater cost efficiencies, but the tradeoff is that they cannot achieve comparable scale and scope. Nor do they benefit from comparable infrastructure and logistics.

Nonetheless, emerging Asia can now benefit from these low-cost advantages as China once did. It could prove a regional win-win story.

FDI shift from manufacturing to services

From China’s standpoint, the relocation trend of low-cost manufacturing to South and Southeast Asia is counter-balanced by a complementary trend, which suggests that othermultinationals are relocating their production facilities within China.

Since late 2011 – according to the most recent data by the United Nations Conference on Trade and Development (UNCTAD) – FDI growth in Asia has slowed because of growing uncertainties in the global economy. In contrast, FDI flows to China reached a historically high level of $124 billion in 2011 (when Hong Kong, too, saw a historic high of $83 billion).

As China is now moving higher in the value-added chain, this is reflected in the incoming FDI. While FDI to manufacturing has stagnated in China, FDI to services is soaring.

China is increasingly attracting market-seeking FDI, especially in services. Recently, FDI flows to services have surpassed those to manufacturing for the first time, as the result of a rise in flows to non-financial services and a slowdown of flows to manufacturing.

Moreover, FDI in finance is expected to grow significantly as the country continues to open its financial markets, and as foreign banks expand their presence through M&As and organic growth.

According to the UNCTAD’s annual World Investment Prospects Survey, China continues to be the most favored destination of FDI inflows. Concurrently, FDI prospects in Southeast Asia remain promising, as the rankings of ASEAN economies, such as Indonesia and Thailand, have risen substantially.

From one-way to two-way relationship

As foreign investment is refocusing within China, Chinese foreign investment is refocusing worldwide, shifting from emerging Asia into the developed markets, including the United States and the Eurozone. In 2012, China’s FDI into the United States enjoyed a record year. Chinese firms completed U.S. deals worth $6.5 billion, a 12 percent increase from the previous record of $5.8 billion in 2010.

In the past, Chinese multinationals invested in resource industries mainly in developing economies. Today, they find the oil and gas extraction as the most attractive sectors in the United States. Other Chinese multinationals are buying into advanced manufacturing operations, which allow them to upgrade their productivity. Still others are investing in slower-growing but stable industries, including hospitality, utilities, and real estate. In the absence of sudden disruption, the growth story is likely to continue in 2013.

In the U.S. and the Eurozone, the accelerating Chinese FDI reflects a shift from the past one-way investment relationship to a genuine, two-way partnership. In turn, this long-anticipated structural story is driven by new FDI growth service engines in Chinese coastal megacities and FDI manufacturing operations in Chinese inland and west, as well as across Southeast Asia.

Foreign investment in China is not declining, but shifting from asset-seeking FDI in first-tiered cities to market-seeking FDI in these megacities and asset-seeking manufacturing FDI elsewhere.

While government-to-government relations go through their friction dramas, market-to-market relations thrive and expand. In the words of an old Arabic proverb, dogs may bark, but the caravan goes on.

Dr. Dan Steinbock is Research Director of International Business at India China and America Institute (USA) and Visiting Fellow at Shanghai Institutes for International Studies (China) and the EU Center (Singapore).